What is efficiency wage theory?

What is efficiency wage theory?

Efficiency wage theory advocates paying your employees higher than the market wage for their role, and states that this is real 'fair pay'. The reason for doing this is not generosity and consideration but through cold hard desire for profit maximisation. The logic behind the theory is simple. Paying your employees above what economists call ‘market equilibrium’ wage levels will impact how much your firm’s employees are motivated to work.

The history of efficiency wage theory is not clear-cut. The term was first used by Alfred Marshall to describe the wage a firm would pay a worker to increase their productivity such that the firm was indifferent between the low efficiency worker and the high efficiency worker. However, this is not really what would be considered an efficiency wage theory today.

The modern field of efficiency wage theory within labour economics is a group of models that all show productivity and efficiency benefits from increasing wages. There is no one founder of the theory but rather a multitude of models exist to explain why the Labour market will give different outcomes depending on the wage offered for a job.

The ‘shirking’ model, developed by Carl Shapiro and Joseph Stiglitz, and the gift exchange model that was put forward by George Akerlof are probably the most significant models in the field. These guys are big hitters in economics -two of the authors are Nobel laureates.

Putting efficiency wage theory in context

Although undergraduate level economics is not often discussed explicitly in the news and current affairs, presumably for fear of boring people to death, you can draw parallels to efficiency wage theory in well publicised wage re-structuring in some very well-known companies. This should start to show you who is backing efficiency wage theory.

One example is Amazon who recently orchestrated a pay rise for their lowest paid staff globally. Part of Amazon’s reason for doing this will have been to improve public perception of their business but beneath this are the classic motivations to improve productivity, efficiency and ultimately profitability- performance based pay can be key to this.

By increasing their staffs’ wages from minimum to living wage Amazon will have hoped to gain several desirable changes within their workforce. Firstly, they hoped that their employee's desire to hold on to their jobs would increase, resulting in a better work ethic. Secondly they expected to have lower staff turnover because the wages they could get elsewhere will now be comparatively less, next they might hope that they will get a spate of new applicants and be able to choose a better standard of employee who is more productive and finally their employees’ health will improve and thus so will the quality of their work.

This example of Amazon should show you that the people who advocate a living wage are not the socialists and left-wing anti-capitalist naive academics you might expect. Instead, those who believe in efficiency wages are scattered across sectors and across the centre of the political spectrum. They believe that the unemployment sector is inefficient and imperfect but that this is largely par for the course and by no-means do they desire government intervention. It’s essential to remember that underneath it all, efficiency wage theory is a neo-liberal project with profit maximisation at its heart. This is not to say that neo-liberals aren’t divided on the subject. Whether you think efficiency wage theory will work also has to depend on the nature of the sector, whether workers are price-takers as it were or instead employers have to bid for their employees. There are many other necessary considerations.

How can paying a higher wage improve your organisations production?

Efficiency Wage theory can be split into four ways that paying a higher wage can improve your organisations production. These are: decreased shirking, increased retention, higher quality recruits, and healthier employees.

1. Less Shirking

This first improvement can tell us a lot about how the neoliberal economist views workers, or human capital as they choose to refer to it. Essentially a member of the workforce is a ‘utility-maximiser’, they view employment as a trade-off between effort and pay so they try to maximise their pay whilst minimising the effort they put into their jobs. Shapiro and Stiglitz’s model of shirking works on these assumptions about your employees.

The model goes like this: it is impossible for firms to completely monitor the effort of all individuals in their employment and some people will take advantage of this and slack off despite the fact that if they are caught shirking they will lose their jobs. If the firm pays market price for wages, then the cost to the employee of losing their job is essentially the cost of finding a new job.

However, if the firm pays their employees more than market price then the cost of losing their job will be significantly higher due to missing out on the higher wages with their present employer. Under these circumstances the employee is incentivised to work harder, not shirk their responsibilities and thus minimise the risk of losing their job. Thus less shirking and more effort.

Your first reaction to this model might be discomfort at the reliance on carrot and stick managerial style where employees fear being fired and desire higher wages only. This is definitely not how you should employ efficiency wages if you were to. The theory is crude by using ‘homo economicus’ to oversimplify employees. Over simplifying economic agents is considered by many to be the main flaw in establishment economics today. A better understanding, taking a looser interpretation of Shapiro and Stiglitz’s model, is to view the maths as capturing a phenomenon in the behavior of your employees that is far more complicated.

It is fairly certain that people do a better job when they are paid more for it. There is a large amount of research in this area in psychology and behavioural economics. Your employees might be more motivated because they feel valued and thus appreciate their employer, or simply want to offer value for money and take pride in what they do.

Our emotions and motivators are exceedingly complex, and economic agents are notoriously over-simplified within economics. But the argument for using higher wages to promote effort that Stiglitz and Shapiro present in their model is empirically supported. Although their argument has issues, the argument that efficiency wages promote greater effort definitely seems reasonable.

2. Increased Retention

Efficiency wages, fairly intuitively, increase the retention in your organisation. You can also see how this is supported by Stiglitz and Shapiro’s model. If you pay your employees more than they would get elsewhere then this will make it less likely that they will leave. You can understand this in economic terms of opportunity cost or you can just see it as common sense: If you are paid more where you are now, then why would you leave? It is a good question but there is probably more to retention than this - what with employees being humans and humans having emotions.

If you are paid more, then loyalty is likely to influence your behaviour. You will commit more to an organisation that values you and is committed to paying you to be comfortable rather than just survive. In these organisations you see employee satisfaction and retention metrics that are much higher.

The business case for retention is obvious. Finding new employees is expensive and losing skills that you have developed as an employer is a waste. Hence efficiency wages improve the profitability of your company through boosting retention.

3. Higher Quality Recruits

This is another simple concept. If you pay your employees more than the market wage, then you will attract and be able to recruit the best people into your organisation. Taking an economic approach to try and explain this truism, - ‘Cause why wouldn’t you!? - you can explain why you get a higher quality of employee through Akerlof’s ‘Gift exchange’ model.

This is an old model that reverberates a lot today because it is uses more than simply utility maximisation to explain the actions of employees. Essentially efficiency wages are seen as a gift that creates ‘good will’ within your teams and organisations and, in exchange for the gift from you to them, you receive their effort and willingness to go the extra mile or take on additional responsibilities.

A good example of this is when you promote someone to a management position. Often this changes how the individual will behave in the way they approach their work. They’ll often stay longer, do more than is required and take on extra responsibilities. Generally you might say they take greater ownership.

There is a rough edge to this though and Akerlof doesn’t really capture it. If the gift you give is obviously accompanied by an expectation or feeling or obligation, then you’re not going to reap the same rewards of good will. You might even fall victim to resentment and other conflicting emotions. You need to use your gifts to cultivate good will without asking for it.

4. Healthier Employees

It’s debatable whether this argument for efficiency wages is applicable in the developed world. However, based on statistics in the UK, wealth and economic status are highly associated with health and well-being. Whether that is because lifestyle diseases are not uniformly distributed across cultures and socio-economic groups, or because a person on minimum wage may be subject to fuel poverty.

The trends are there for us to see. Amazon’s workers were publicly revealed to be living in camps at the sides of motorways in the past and you would hope that that might have changed at least marginally since they increased their wages.

As this is about the economic benefits to employers of efficiency wages we still need to justify paying higher wages to boost health, even though it seems self-evident that this should be done. If you pay your employees more and this benefits their health, then they will be better employees.

They will take less sick leave, be able to sustain better levels of concentration and find focusing easier. If they are healthy they will probably be happy and thus more motivated. So even if you weren’t moved to pay more by just the health of your employees itself, you should care about their health because it will improve productivity and long run profitability.

How should you assess if you should implement efficiency wages?

It seems that these reasons for why efficiency wage theory can benefit your business are pretty strong. But why isn’t everyone doing it then?

You need to consider a number of things before trying to offer efficiency wages sustainably. You may want to help your employees, but if you go out of business trying to pay them more they won’t thank you. A lower wage is better than no wage.

You need to find out if it’s sustainable. Efficiency wages are a bid to acquire the best work force, your rival bidders are the other employers in your sector. Competition for the best can be fierce especially if there is a shortage in the labour market. Make sure you know the market for employees in your sector and the buying power of your competitors. You don’t want to bite off more than you can chew and end up increasing wages but still paying the least in the industry.

Going back to Marshall at the start, you need to make sure you know what the extra effort from your employees and the boost in productivity is worth to your business before you try to stimulate this boost. The key will be not paying more than this because this will not be sustainable.

Finally, remember not to over-simplify your employees. Good management and emotional intelligence might achieve the changes you wanted without having to address wages at all. Be pragmatic. Efficiency wages are clearly going to help boost productivity but if you could have done this without increasing wage costs then there are clearly other things you need to focus on more!

It comes down to knowing your organisation, your sector and the nature of the people in both. Researching this and looking into the models and economics I’ve outlined above will not go unrewarded. Get informed.