Efficiency Wages

Imagine you own a software company, and you have a very skilled programmer. Your company's success depends on this highly professional programmer's work. How much would you be willing to pay him to make sure that he keeps working for you? Surely, not a market wage, as another company would be willing to give him an offer in a matter of seconds. You will probably have to pay this programmer way above the market wage, and it will be truly worth it. To understand why and how you need to know about efficiency wages!

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Table of contents

    Efficiency wages are wages employers pay to employees to prevent them from quitting. Are all wages efficient? Do all employees get paid more? Why don't you read on and find out all there is about efficiency wages!

    Efficiency Wages Definition

    Efficiency wages definition refers to wages that employers pay their employees to ensure that the employee does not have the incentive to quit the job. The main goal of efficient wages is to retain highly skilled workers. Additionally, efficiency wages motivate individuals to become more productive, which results in a company bringing more revenue in.

    Efficiency wages are wages that an employer agrees to give to an employee as an incentive for them to remain loyal to the company.

    When a labor market is in perfect competition or at least close to perfect competition, it is possible for all individuals seeking a job to find one. The income those individuals make is set according to their marginal labor productivity.

    However, efficiency wage theory assumes that paying workers at their marginal productivity of labor does not provide enough of an incentive for workers to remain loyal to the company. In such a case, the company should increase the employer's wage to gain loyalty and boost productivity at work.

    Check out our article on the Perfectly Competitive Labor Market

    to find out how the demand and supply of labor work in a competitive labor market!

    Reasons why companies keep paying efficiency wages

    Although the labor market is competitive and individuals who want to work are assumed to be able to find work, unemployment rates in many countries remain high.

    It seems likely that a significant portion of those who are now without jobs would accept wages that are even lower than those currently held by those in gainful employment. Why don't we see businesses lowering their pay rates, boosting their employment levels, and, as a result, raising their profits?

    That's because, although businesses might be able to find cheaper labor and replace their existing workers, they do not have the incentive to do so. Their current workers have the skills and expertise to do the job much more productively than any new worker working for a lower wage would. These companies are said to be paying efficient wages.

    Labor productivity, which is strongly correlated with the employees' skills, impacts a company's profits. Efficiency wage models acknowledge that the pay rate is an important contributor to the overall level of worker productivity. There are many reasons for that.

    The income that workers receive directly influences their lifestyle, which then impacts their overall physical and mental health. Workers that lead a healthy and happy lifestyle are more productive at workplaces than other workers who struggle to make ends meet.

    For example, workers who get higher wages have the financial means to purchase more and better food, and as a result, they have better health and can work more effectively.

    Efficiency wages may also be given to ensure the loyalty of employees. Employees in sectors, such as those working with precious metals, jewels, or finance, may also be given efficiency payments to help ensure employees' loyalty. This is to ensure that these workers do not go and work for the company's main competitor.

    The company must retain the skills of these employees as well as the knowledge they have of the business practices and methods of the firm.

    For example, there might be workers in finance that bring many new clients to the bank, directly impacting the bank's profitability. Clients may come because they like the employee, and they may decide to leave if that employee leaves the bank.

    To ensure that this employee stays working for the bank and retains the client, the bank pays an efficient wage. Hence, you have certain bankers receiving extraordinary bonuses for their work.

    Efficiency Wages Examples

    There are many efficiency wages examples. Let's go through a few of them!

    Imagine a senior developer at Apple going to work for Samsung. It would enhance Samsung's competition. That's because Samsung would benefit from the knowledge that the developer has and has gained while working for Apple. This would help Samsung make products that are at the same level or even better than Apple.

    To prevent this from happening, Apple has to make sure that their senior developer is adequately compensated so he doesn't have any incentive to leave his job at Apple.

    Efficiency wages Apple building StudySmarterFig. 1 - Apple building

    An Apple Senior Developer earns, on average, $216,506 annually, including base salary and bonuses.1

    The total compensation of an Apple Senior Developer is $79,383 above the US average for similar roles.1

    Amazon is another good example of efficiency wages, as the company has decided to increase its minimum wage, which benefits its employees worldwide.

    Amazon's increase in the wages it pays its workers aims to improve the company's productivity, efficiency, and, ultimately, profit.

    The company's main goal was to improve its employees' work ethic and reduce the turnover rate of its staff. Additionally, they also aimed at increasing their employees' health by providing an efficiency wage, which would enhance the quality of their work.2

    Efficiency Wage Theory of Unemployment

    The efficiency wage theory of unemployment is a theory that explains how companies are willing to increase the wage of their employees to make sure they keep their job. Additionally, the efficiency wage theory explains why there is unemployment and wage discrimination and how labor markets are affected by the wage rate.

    According to the efficiency wage theory, an employer should pay their employees enough to ensure that they are motivated to be productive and that highly competent employees do not abandon their jobs.

    To better understand the efficiency wage theory, we need to consider the shirking model.

    Shirking model states that employees are incentivized to shirk if a firm pays them a market-clearing wage. That's because even if they get fired, they can find a job elsewhere.

    If you are someone who watches TikTok a lot, you probably must've heard about quiet quitting.

    Quiet quitting happens when employees basically do their bare minimum at work, which is what shirking is.

    The shirking model assumes that the labor market is in perfect competition, and all workers earn the same wage rate and have the same productivity levels.

    It is very expensive or not practicable for many businesses to monitor their employees' activity at work. As a result, these businesses have imprecise information on the productivity of their employees.

    As soon as they are employed, employees can either work hard or slack off. However, because there is a lack of information regarding the employees' performance, it is possible that their employment will not be terminated for their lack of effort.

    To put that in perspective, it is hard for a company to monitor their worker's activity and fire them for shirking. So instead of having quiet quitters walking around offices or factories, a company chooses to pay an efficient wage, providing the incentive to be productive. Efficiency wages that are high enough provide no incentive for workers to shirk.

    Efficiency Wage Theory of Unemployment: Efficiency Wage Theory Graph

    Figure 2 below explains how a firm sets its efficiency wage so that individuals have no incentive to shirk and work at their maximum productivity possible.

    Efficiency wages Efficiency wage graph StudySmarterFig. 2 - Efficiency wages graph

    Initially, the labor market consists of the demand curve (DL) and supply curve (SL) for labor at point 1. The intersection between the labor supply and labor demand provides the equilibrium wage, which is w1, where full employment occurs. However, companies are not willing to pay their employers this wage as they will have no incentive to be productive at work.

    Instead, to motivate employees to be productive, businesses need to offer a wage higher than w1 regardless of the unemployment rate in the labor market.

    The no-shirking constraint curve (NSC) is the curve that illustrates what wage a company should pay to provide enough incentive for workers to be productive.

    The point where the NSC curve and the demand curve intersect provides the efficiency wage companies should pay to employees. This occurs at point 2, where the wage rate is w2, and the quantity of labor employed is Q2. At this point, the unemployment rate is much higher than at the equilibrium point 1, where the demand curve intersects the supply of labor.

    Notice also that as the difference between the efficient wage (w2) and the market wage (w1) narrows, the unemployment rate decreases (the number of people employed increases). That means that an efficiency wage is one reason economies face high unemployment rates.

    Efficiency Wage Theory Assumptions

    There are some key efficiency wage theory assumptions. One of the primary assumptions of the efficiency wage theory is that the labor market is in competition. All workers get the same salary and have equal productivity. However, as firms can't monitor their workers' activity, workers do not have the incentive to be as productive in the workplace as they can.

    To boost productivity of workers, the efficiency wage theory assumes that firms need to pay workers more than the market-clearing wage. This then provides the incentive to workers to be as productive as possible, leading to an increase in the firm's overall output.

    Additionally, the efficiency wage theory assumes that when workers are paid a market wage, the demand for workers is high, which makes it easier for someone to find another job if they are fired. This then causes employees to be lazy and less productive at work.

    Efficiency Wage Theory vs. Involuntary Unemployment

    There is a direct link between efficiency wage theory vs. involuntary unemployment.

    To understand it, let's consider the meaning of involuntary unemployment.

    Involuntary unemployment occurs when an individual is unemployed, although they are willing to work at the market equilibrium wage.

    Efficiency wage theory requires that workers are paid more than the equilibrium wage to retain their job and be more productive. However, when workers are paid above the minimum wage, there will be a labor surplus. This surplus of labor consists of involuntarily unemployed individuals.

    Everyone wants to work at a higher than market wage, or efficiency wage; however, only some people are selected by companies, leading to involuntary unemployment.

    Efficiency wage amplifies the increase in the involuntary unemployment rate during an economic recession. That's because companies do not want to lower the wages to not lose their highly skilled workers; instead, they will fire less skilled workers to cut costs. This then leads to a higher involuntary unemployment rate.

    Efficiency Wages - Key takeaways

    • Efficiency wages are wages that an employer agrees to give to an employee as an incentive for them to remain loyal to the company.
    • Labor productivity, which is strongly correlated with the employees' skills, impacts a company's profits.
    • According to the efficiency wage theory, an employer should pay their employees enough to ensure that they are motivated to be productive and that highly competent employees do not abandon their jobs.
    • Shirking model states that employees are incentivized to shirk even if a firm pays them a market-clearing wage.

    References

    1. Comparably, Apple Senior Developer Salary, https://www.comparably.com/companies/apple/salaries/senior-developer
    2. Harvard Business Review, How Amazon's Higher Wages Could Increase Productivity, https://hbr.org/2018/10/how-amazons-higher-wages-could-increase-productivity
    Frequently Asked Questions about Efficiency Wages

    What is meant by efficiency wages?

    Efficiency wages are wages that an employer agrees to give to an employee as an incentive for them to remain loyal to the company.

    What are the four types of efficiency wage theory?

    Four types of efficiency wage theory include decreased shirking, increased retention, quality recruits, and healthier workers.

    How do efficiency wages cause unemployment?

    By increasing the wage above the market wage where there is less demand for workers.

    What does the efficiency wage theory suggest?

    The efficiency wage theory suggests that an employer should pay their employees enough to ensure that they are motivated to be productive and that highly competent employees do not abandon their jobs

    What is the reason for efficiency wages?

    The reason for efficiency wages is to ensure that employees are motivated to be productive and that highly competent employees do not abandon their jobs.

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