Efficiency wage
In labor economics, an efficiency wage is a wage paid in excess of the market-clearing wage to increase the labor productivity of workers. Specifically, it points to the incentive for managers to pay their employees more than the market-clearing wage to increase their productivity or to reduce the costs associated with employee turnover.
Theories of efficiency wages explain the existence of involuntary unemployment in economies outside of recessions, providing for a natural rate of unemployment above zero. Because workers are paid more than the equilibrium wage, workers may experience periods of unemployment in which workers compete for a limited supply of well-paying jobs.
Overview of theory
There are several reasons why managers may pay efficiency wages:- Avoiding shirking: If it is difficult to measure the quantity or quality of a worker's effortand systems of piece rates or commissions are impossible, there may be an incentive for the worker to "shirk". The manager thus may pay an efficiency wage in order to create or increase the cost of job loss, which gives a sting to the threat of firing. This threat can be used to prevent shirking.
- Minimizing turnover: By paying above-market wages, the worker's motivation to leave the job and look for a job elsewhere will be reduced. This strategy also reduces the expense of training replacement workers.
- Selection: If job performance depends on workers' ability and workers differ from each other in those terms, firms with higher wages will attract more able job-seekers, and this may make it profitable to offer wages that exceed the market clearing level.
- Sociological theories: Efficiency wages may result from traditions. Akerlof's theory involves higher wages encouraging high morale, which raises productivity.
- Nutritional theories: In developing countries, efficiency wages may allow workers to eat well enough to avoid illness and to be able to work harder and even more productively.
Shirking
A theory in which employers voluntarily pay employees above the market equilibrium level to increase worker productivity. The shirking model begins with the fact that complete contracts rarely exist in the real world. This implies that both parties to the contract have some discretion, but frequently, due to monitoring problems, the employee's side of the bargain is subject to the most discretion. Methods such as piece rates are often impracticable because monitoring is too costly or inaccurate; or they may be based on measures too imperfectly verifiable by workers, creating a moral hazard problem on the employer's side. Thus, paying a wage in excess of market-clearing may provide employees with cost-effective incentives to work rather than shirk.In the Shapiro and Stiglitz model, workers either work or shirk, and if they shirk they have a certain probability of being caught, with the penalty of being fired. Equilibrium then entails unemployment, because to create an opportunity cost to shirking, firms try to raise their wages above the market average. But since all firms do this, the market wage itself is pushed up, and the result is that wages are raised above market-clearing, creating involuntary unemployment. This creates a low, or no income alternative, which makes job loss costly and serves as a worker discipline device. Unemployed workers cannot bid for jobs by offering to work at lower wages since, if hired, it would be in the worker's interest to shirk on the job, and he has no credible way of promising not to do so. Shapiro and Stiglitz point out that their assumption that workers are identical is a strong one – in practice, reputation can work as an additional disciplining device. Conversely, higher wages and unemployment increase the cost of finding a new job after being laid off. So in the shirking model, higher wages are also a monetary incentive.
Shapiro-Stiglitz's model holds that unemployment threatens workers, and the stronger the danger, the more willing workers are to work through correct behavior. This view illustrates the endogenous decision-making of workers in the labor market; that is, workers will be more inclined to work hard when faced with the threat of unemployment to avoid the risk of unemployment. In the labor market, many factors influence workers' behavior and supply. Among them, the threat of unemployment is an essential factor affecting workers' behavior and supply. When workers are at risk of losing their jobs, they tend to increase their productivity and efficiency by working harder, thus improving their chances of employment. This endogenous decision of behavior and supply can somewhat alleviate the unemployment problem in the labor market.
The shirking model does not predict that the bulk of the unemployed at any one time are those fired for shirking, because if the threat associated with being fired is effective, little or no shirking and sacking will occur. Instead, the unemployed will consist of a rotating pool of individuals who have quit for personal reasons, are new entrants to the labour market, or have been laid off for other reasons. Pareto optimality, with costly monitoring, will entail some unemployment since unemployment plays a socially valuable role in creating work incentives. But the equilibrium unemployment rate will not be Pareto optimal since firms do not consider the social cost of the unemployment they helped to create.
One criticism of the efficiency wage hypothesis is that more sophisticated employment contracts can, under certain conditions, reduce or eliminate involuntary unemployment. The use of seniority wages to solve the incentive problem, where initially, workers are paid less than their marginal productivity, and as they work effectively over time within the firm, earnings increase until they exceed marginal productivity. The upward tilt in the age-earnings profile here provides the incentive to avoid shirking, and the present value of wages can fall to the market-clearing level, eliminating involuntary unemployment. The slope of earnings profiles is significantly affected by incentives.
However, a significant criticism is that moral hazard would be shifted to employers responsible for monitoring the worker's efforts. Employers do not want employees to be lazy. Employers want employees to be able to do more work while getting their reserved wages. Obvious incentives would exist for firms to declare shirking when it has not taken place. In the Lazear model, firms have apparent incentives to fire older workers and hire new cheaper workers, creating a credibility problem. The seriousness of this employer moral hazard depends on how much effort can be monitored by outside auditors, so that firms cannot cheat. However, reputation effects may be able to do the same job.
Labor turnover
"Labor turnover" refers to rapid changes in the workforce from one position to another. This is determined by the ratio of the size of the labor and the number of employees employed. With regards to the efficiency wage hypothesis, firms also offer wages in excess of market-clearing, due to the high cost of replacing workers. If all firms are identical, one possible equilibrium involves all firms paying a common wage rate above the market-clearing level, with involuntary unemployment serving to diminish turnover. These models can easily be adapted to explain dual labor markets: if low-skill, labor-intensive firms have lower turnover costs, there may be a split between a low-wage, low-effort, high-turnover sector and a high-wage, high effort, low-turnover sector. Again, more sophisticated employment contracts may solve the problem.Selection
Similar to the shirking model, the selection model also believes that the information asymmetry problem is the main culprit that causes the market function not fully to exert to eliminate involuntary unemployment. However, unlike the shirking model, which focuses on employee shirking, the election model emphasizes the information disadvantage of employers in terms of labor quality. Due to the inability to accurately observe the real quality of employees, we only know that high wages can hire high-quality employees, and wage cuts will make high-quality employees go first. Therefore, wages will not continue to fall due to involuntary unemployment to maintain the excellent quality of workers.In selection wage theories it is presupposed that performance on the job depends on "ability", and that workers are heterogeneous concerning ability. The selection effect of higher wages may come about through self-selection or because firms with a larger pool of applicants can increase their hiring standards and obtain a more productive workforce. Workers with higher abilities are more likely to earn more wages, and companies are willing to pay higher wages to hire high-quality people as employees.
Self-selection comes about if the workers’ ability and reservation wages are positively correlated. The basic assumption of efficiency wage theory is that the efficiency of workers increases with the increase of wages. In this case, companies face a trade-off between hiring productive workers at higher salaries or less effective workers at lower wages. These notes derive the so-called Solow condition, which minimizes wages even if the cost of practical labor input is minimized. Solow condition means that in the labor market, the wage level paid by enterprises should equal the marginal product of workers, namely the market value of labor force. This condition is based on two basic assumptions: that firms operate in a competitive market and cannot control market wages and that individual workers are price takers rather than price setters. If there are two kinds of firms, then we effectively have two sets of lotteries, the difference being that high-ability workers do not enter the low-wage lotteries as their reservation wage is too high. Thus low-wage firms attract only low-ability lottery entrants, while high-wage firms attract workers of all abilities. Therefore high-wage firms are paying an efficiency wage – they pay more and, on average, get more. However, the assumption that firms cannot measure effort and pay piece rates after workers are hired or to fire workers whose output is too low is quite strong. Firms may also be able to design self-selection or screening devices that induce workers to reveal their true characteristics.
High wages can effectively reduce personnel turnover, promote employees to work harder, prevent employees from resigning collectively, and effectively attract more high-quality employees. If firms can assess the productivity of applicants, they will try to select the best among the applicants. A higher wage offer will attract more applicants, particularly more highly qualified ones. This permits a firm to raise its hiring standard, thereby enhancing its productivity. Wage compression makes it profitable for firms to screen applicants under such circumstances, and selection wages may be necessary.