The Concept of Efficiency Wages

Question:

Provide Examples of Companies which use Efficiency Wages Methods.

The factors used in production process earns a return. Labor is an important factor of production and receives wage as remuneration. The forces of demand and supply in the labor market generally determine the wage paid to the employees. The structure of wage and employment is a crucial determinant of wage. Factors influencing the productivity of labor in private as well as in public have contested long. Wage is a primary influencing factor of labor supply and productivity. A wage above the equilibrium wage generally creates an oversupply of labor and hence unemployment. In the presence of strong bargaining power of union employers often forced to set wage above the equilibrium wage. When employers pay wage above equilibrium wage to enhance productivity without any force then it is called efficiency wage. One contradictory theory of efficiency wage is that of the theory of backward bending labor supply curve. The theory suggests, increases in wage increases labor supply to a certain level. Beyond that, point labor supply decreases as labor gives priority to leisure above their labor time.

In this paper, the theory of efficiency wage is discussed and the relation between pay and performance is analyzed. The issues are draw from relevant literature and related with labor policies of a well-established company in Australia.

In literature, the structure of wage and differences in the prevailing wage level is widely discussed because of its long held implications on living standard of labors and productivity. With passes of time, the structure of wage and employment has changed in industries. Different wage theories and models are proposed to explain the incidence of wage and examine those theories with some practical evidences.

The theory of equitable wage is one of the important theories in literature of wage structure. The theory suggests that existing poverty and inequality contributes to increasing wage gap among the labor force. The differences in wage here are explained with discrepancies in the job profile, in firms’ structure, differences in economic condition and development status and composition of society (Schmitt, 2013). The equitable wage distribution is seen as a way of mitigating inequalities in these countries. The theory has little to do with efficiency of workers and firms’ productivity and this opens a door to critic of this theory.

Pay for performance model provides an argument for wage inequality on ethical ground. The high payment scheme gives worker incentive to give greater work effort and enhance productivity. Overtime the workers develop their skills as encouraged by the higher wages. The skilled and good quality workers increase overall productivity of firms. Many literatures support the pay for performance model. This theory suggests when workers receive a high wage then an improvement in performance in realized. However the ability of the worker within firms differs and this difference in skills results in inequality in wage payment. Here wage is paid according ti their performance. The argument of this model is quite similar to the theory of efficiency wage.

Theoretical Models Supporting Efficiency Wages

Scholars had devoted much of their time to explore wage several wage theories that exit in different economies.  One such theory counters the proposed theory of equal wage distribution. The counter arguments indicate that the theory of equal distribution of wages may seem appealing from a social perspective of equality but it not economical at all (Co?ar,  Guner & Tybout, 2016). The equal wage reduces the incentives of additional work effort. In some situation it is reasonable to exit an inequality of wage. There are some common trends of wage inequality that has proven beneficial for the firm as well as for the workers.

Efficiency wage is a above equilibrium wage that is paid to increases efficiency of laborers. Unemployment is a situation where a surplus labor exists in the labor market. The legislated minimum wage leads to an excess supply of labor as labor demand reduces in response to a high wage.  Both minimum wage and efficiency wage is set above the equilibrium level however employers’ motivations are different in the two situations. According to this theory, high wage encourages workers to put more effort and increases profitability of the firms operation (Du Caju et al., 2015). Here, firms are considered to be better off from offering a high wage. There are different theoretical models giving different rationale for paying a high wage. The widely discussed models are as follows.

In a firm, the wages offered to the workers determine the workers’ quality. Firms intend to attract most productive workers in their labor force. The quality of the workers cannot be assessed by the firms ideally. Firms use the tool of wage to have a better quality workforce. It is assumed that when a high wage is offered then better quality workers will be interested for the job than they otherwise are (Guerrazzi & Sodini, 2017). Low wage reduces the work incentive and skilled workers may find it as a state of underemployment. The claim of efficiency wage is supported when wage turns out an important attribute of workers quality.

The workers’ turnover model points toward the inverse relationship between workers between turnover of workers and a relatively high wage. There are several reasons for which workers decide to quit their jobs. Workers may find a mismatch between the job profile and their skill, may want to relocate in some other industries and more often to get a better payment and the like. Wages or work incentive here is one crucial factor here. In deciding whether to quit their jobs, workers do costs benefit analysis of staying or quitting their existing jobs (Pashardes, Polycarpou & Polycarpou, 2015). When opportunity cost of quitting a job is higher, they decide to continue in their jobs.

Efficiency Wages in Practice: Examples from Well-Known Companies

Firms always want to make the turnover rate as minimum as possible. It is beneficial for firms to retain their existing workers than to hire fresh workers and train them. In order to retain productive and experienced workers firms offer a high wage, a wage above that prevail in the market.

Productivity in an industry is highly depended on the work effort given by the workers. It is at the discretion of workers regarding how much effort to put. Firms may enforce monitoring devices or employ supervisors to monitor the work effort but monitoring is costly and lacks transparency. Even when worker who caught shirking their responsibilities are driven away from their jobs it is not possible to completely cease the practice (Roy, 2016). Therefore, it is better to incentivize the workers such that losing current jobs entails enough opportunity cost that workers put forward their best effort. Wage is the form of incentive and the model thus support the hypothesis asserts in efficiency wage theory.

This is another argument in favor of paying a high wage to workers particularly applicable in developing or underdeveloped countries. In poor countries, equilibrium wage determined in the market may not be sufficient that the workers can afford a healthy and nutritious diet. The health condition of workers has direct effect on productivity. Therefore, employers in these countries consider to give a wage such that they can have healthy diet and improves productivity (Verhoogen, 2015). In developed countries the argument is not much applicable as most of the workers there receive sufficient wages to carry out healthy diet.

The labor market segmentation theory is rooted in the practice of wage discrimination as evidenced in twentieth century. Since then different levels of wage and job securities exist in the labor market. In a segmented labor markets different there are different sub market in the labor market each having a different condition. However, in real world the distinction among the sub markets are not clearly visible and often overlap. Three well known segments are regional market, professional market and branch market. Existence of a dual economy is the basis for existence of labor market segmentation. The dual economy is characterized with a high income and low income sectors.

Primary and secondary labor market segment are two other categories of labor market segmentation. Laborers in the secondary sector generally do not enter in the primary sector as characterized by senior job posts. In the secondary labor market segment workers hyave low wage income and works in poor work environment (Stiehl et al., 2017). In this segment high wage acts as a tool to improve worker condition and prevent workers’ turnover.

Conclusion

The efficiency wage theory as limited explanation for backward bending labor supply curve. In the short run an increase in wage generally increases labor supply. The wage effect can be decomposed into income effect and substitution effect same as price effect. The substitute to work effort here is leisure. Beyond a critical point increased wage encourages workers to substitute more leisure in place of work effort. This makes the labor supply curve backward bending.

Figure 1: Backward bending labor supply curve

(Source: Pashardes, Polycarpou & Polycarpou, 2015)

Apart from derivation of theoretical models of efficiency wage studies have conducted to empirically verify the efficiency wage assertion. Studies during 1980s and 1990s failed to find strong support in Australian labor market. However, some evidences are there that support efficiency wages in favor of voluntary unemployment in the nation. A highly contested field of research is worker motivation in public sector and prevailing wages (Booth, 2014). Studies reveal that wages in private sector differ significantly from that in public sector. Empirical evidences find a high elasticity value of Public sector motivation implying motivation plays an important role in affecting work effort.

The famous automobile company Henry Ford practically implement the theory of efficiency wage. In 1914, Ford introduced a wage rate of five dollar. It is twice the average wage rate of automakers at that time. Ford’s decision of offering a high wage to its workers give relevance to the theory of efficiency wage for determination of employment. The policy has proved effective for raising Ford’s productivity and associated profitability. Earlier Ford was paying a wage of $2.34 for working nine hour per day. The wage level doubled to become $4.80 per day (Wilson, 2014). The higher wage in Ford created pressure on its competitors. Many of them tried to match the wage level of Ford but utterly failed and some of them went bankrupt. This was a surprising move of Ford while compared to other manufacturers setting wage at least possible figure. In exchange of the high wage, Ford believed to retain workers committed to high quality work. Ford considered the price rise to be necessary to have workers to handle the pressure from business expansion. Another rationale for giving high wage to the workers to raise the purchasing power the workers so that they can increase their demand. In 1919, Ford again revise their wage and set the minimum wage as $6.00. Today also, Henry Ford paid a high wage to improve efficiency of workers.

The Fair Work Commission should have close look the relevant theories of efficiency wage and employment. Implementation of efficiency wage is beneficial when giving extra payment increases the productivity of the workers. Looking at the experience of Henry Ford, which benefitted from paying their workers a high wage Fair Work Commission, can adapt this policy. However, the organization should also consider the increasing cost of resulted from high wage. The commission should set wage to the level, which is slightly above the market equilibrium level while also considering the aspect of cost.

The report analyzes efficiency wage hypothesis with relevance to literature and empirical evidences. There are several theoretical model that explains why giving high wage may prove beneficial for firm. The commonly known models are shirking model, mode of adverse selection and worker turnover model. Literature finds some support of the theory in Australia. However, for public sector motivation plays a much bigger role than efficiency wage. Henry Ford has already implemented the theory long before and enjoys positive fruits of this policy.

References

Booth, A. L. (2014). Wage determination and imperfect competition. Labour Economics, 30, 53-58.

Co?ar, A. K., Guner, N., & Tybout, J. (2016). Firm dynamics, job turnover, and wage distributions in an open economy. The American Economic Review, 106(3), 625-663.

Du Caju, P., Kosma, T., Lawless, M., Messina, J., & Rõõm, T. (2015). Why firms avoid cutting wages: Survey evidence from European firms. ILR Review, 68(4), 862-888.

Guerrazzi, M., & Sodini, M. (2017). Efficiency-wage competition and nonlinear dynamics. Communications in Nonlinear Science and Numerical Simulation.

Pashardes, P., Polycarpou, A., & Polycarpou, A. (2015). A backward-bending and forward-falling semi-log model of labour supply (No. 03-2015). University of Cyprus Department of Economics.

Roy, S. (2016). Efficiency Wage Models and Different Policy Implications. The International Journal of Business & Management, 4(1), 268.

Schmitt, J. (2013). Why does the minimum wage have no discernible effect on employment?. Center for Economic and Policy Research, 22, 1-28.

Stiehl, E., Shivaprakash, N., Thatcher, E., Ornelas, I. J., Kneipp, S., Baron, S. L., & Muramatsu, N. (2017). Worksite Health Promotion for Low-Wage Workers: A Scoping Literature Review. American Journal of Health Promotion, 0890117117728607.

Verhoogen, E. (2015). Essays on External Conditions and Wage Setting within Firms. Members-only Library.

Wilson, J. M. (2014). Henry Ford vs. assembly line balancing. International Journal of Production Research, 52(3), 757-765.