Efficiency Wages

Efficiency Wages

What are the Effective Wages?

In the field of labor economics efficiency wages are an amount of money which are paid to employees above what is considered to be the minimal wage in order to keep the most skilled and productive workforce. The theory of efficiency wage states that an employer should pay its employees at a high level to incentivize workers to perform well and highly skilled workers don’t quit. Efficiency wages could be also paid to employees who need a significant amount of trust, such as those who work in the fields of precious metals, jewels or finance, to keep them loyal.

Efficiency wage theory can explain why businesses appear to pay more for labor. The theory argues that higher wages boost overall productivity and profits for firms in the long term.

Understanding the Efficiency Wages

Efficiency wages were thought of from the 18th century, and the famous economics professor Adam Smith identified a form of wage inequity that employees in certain sectors are paid higher than others due to the level of trustworthiness that is required. In one instance Smith observed that workers working for jewelers or goldsmiths although they were often as skilled as those employed by blacksmiths, or other craftsmen were paid a higher rate each hour. 1 Smith believed that this was because of the need to encourage these workers to avoid taking these products that are more valuable.

In more contemporary settings efficiency wages are the fact that some employers are not willing to cut their wages below the minimal wage even in presence of competition from rival firms or in times of recession , when a large workforce of people who are unemployed is available. This was unsettling for some economists who were based on the idea that business owners with a rational mindset and efficient labor markets should aim to keep wage levels as low as they can.

The answer to this puzzle is that efficiency wages resolve the principal-agent dilemma and, without the high pay employers would have a difficult time to keep their employees engaged and loyal.

Why do we pay efficiency wages?

The economists have come up with a variety of reasons for employers to pay more efficient pay to workers. 2 3


The most commonly used are:

  • Reduce the rate of employee turnover Increased wages can discourage employees from quitting. This is particularly true if recruiting and training new employees is a lengthy and expensive process.
  • Increase morale Also an efficiency wage could keep employees happy and decrease the number of unhappy employees that can lower morale in the workplace and reduce production.
  • Enhance productivity Increased wages result in more productive employees who can produce more products per hour and put in more effort. They also decrease shirks (being lazy at work) and reduce absences.
  • To retain and attract skilled workers Although workers who are not skilled might be considered to be somewhat interchangeable in the eyes of management high-skilled workers are usually in higher demand and in shorter supply.
  • Loyalty and trust The higher-paying employees tend to remain loyal their employers and are much more likely not to be stealing from or lower the bottom line of the company.

Efficiency Wage Theory

The concept of efficiency wages has been around for a few years, this concept established by economists in the second half of 20th century. Some notable examples are Joseph Stiglitz and his research on shirks. In collaboration with his fellow colleagues Stiglitz suggested that when unemployment is high, those who are fired can find new work. But, this also increases the chances that a worker will be excused for being unproductive or lazy (i.e., “shirk on the job”). However, as shirking can reduce the company’s profits and profits, employers are compelled to increase wages to combat this and encourage their employees. 2 Stiglitz received the Nobel prize in economics in 2001, primarily due to this research.

George Akerlof also a Nobel prize winner, also was a researcher on the efficiency of wages, suggesting that wages will remain ” sticky,” even during times of economic turmoil in which employers do not cut the wages for their workers. Instead, to save money employers may fire employees (instead of hiring more employees who earn a lower wage). But, this can increase the percentage of involuntary unemployment. Pay is not set by the market for jobs but rather the goals of productivity for firms who must hire the best workers. Akerlof working alongside Janet Yellen suggested that businesses can reduce training and hiring expenses by cutting some employees as the economy is struggling instead of reducing wages for all its employees in all.

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