Efficiency Wage Theory

Definition

Efficiency wage theory is an economic concept that explains how employers may find it profitable to pay workers higher-than-market-clearing wages in order to increase worker productivity and reduce employee turnover. This theory suggests that wages can affect the quality and effort of the workforce, and that firms may strategically set wages above the market-clearing level to achieve greater efficiency.

5 Must Know Facts For Your Next Test

1. Efficiency wage theory suggests that higher wages can lead to increased worker productivity, as employees are motivated to work harder to maintain their above-market wage.
2. Paying efficiency wages can reduce employee turnover, as workers are less likely to leave a job that pays a premium compared to the market wage.
3. Firms may use efficiency wages to attract higher-quality workers, as the higher wage signals that the job is desirable and the employer values employee skills and effort.
4. Efficiency wage theory can help explain why wages may not always adjust to clear the labor market, as employers may find it profitable to pay a wage above the market-clearing level.
5. The costs of employee turnover, such as recruitment and training, can provide an incentive for firms to pay efficiency wages to retain valuable workers.

Review Questions

• Explain how the efficiency wage theory relates to the concept of an imperfectly competitive labor market.
  • In an imperfectly competitive labor market, employers have some degree of market power, allowing them to pay wages below the competitive level and still attract workers. The efficiency wage theory suggests that employers may find it profitable to pay wages above the market-clearing level in order to increase worker productivity and reduce employee turnover. This is because higher wages can motivate employees to work harder and be less likely to leave the firm, which can offset the higher wage costs for the employer. The efficiency wage theory helps explain why wages may not always adjust to clear the labor market in an imperfectly competitive setting.
• Describe how the concept of 'shirking' is related to the efficiency wage theory.
  • The efficiency wage theory suggests that paying higher-than-market wages can reduce the incentive for employees to 'shirk' or reduce their effort and work output below the level expected by the employer. When workers are paid an efficiency wage, they have a stronger motivation to maintain their above-market wage by exerting greater effort and avoiding behaviors that could jeopardize their employment. The threat of losing the premium wage serves as a deterrent against shirking, as workers recognize that their productivity and effort level can directly impact their continued employment and access to the efficiency wage. By reducing shirking, efficiency wages can lead to increased worker productivity and improved firm performance.
• Analyze how the efficiency wage theory can help explain the persistence of unemployment in an imperfectly competitive labor market.
  • The efficiency wage theory suggests that in an imperfectly competitive labor market, employers may find it profitable to pay wages above the market-clearing level in order to increase worker productivity and reduce employee turnover. This can lead to a situation where the wage is 'stuck' above the level that would clear the labor market, resulting in persistent unemployment. Firms may be unwilling to lower wages, as doing so could reduce worker effort and increase turnover, offsetting any potential cost savings. Additionally, the higher efficiency wages paid by some firms can make it difficult for other firms to attract workers, as job-seekers may be reluctant to accept lower wages. This dynamic can contribute to the persistence of unemployment, as the market-clearing wage is not achieved. The efficiency wage theory, therefore, provides an important explanation for why wages and employment levels may not adjust to fully clear the labor market in an imperfectly competitive setting.

Related terms

Imperfectly Competitive Labor Market: An imperfectly competitive labor market is one where employers have some degree of market power, allowing them to pay wages below the competitive level and still attract workers.

Shirking: Shirking refers to employees reducing their effort or work output below the level expected by the employer, which can negatively impact productivity.

Labor Turnover: Labor turnover is the rate at which employees leave a company and are replaced by new hires, which can be costly for the employer.