Efficiency wage
Definition
An efficiency wage is a wage paid by a firm to its workers that is above the competitive wage, i.e., above the equilibrium wage determined by the market for that work. The term efficiency wage is not used specifically either for the total wage paid or the difference between the wage paid and the market wage. Rather, it is used for the overall concept.
Causes for efficiency wage
Improving worker productivity
Higher wages may lead to greater productivity of workers, in the following direct and indirect ways:
- Higher wages allow workers to take greater care of their health and living conditions. It may also enable them to buy more goods and services or engage in other activities that improve their general satisfaction with life.
- Higher wages from an employer may make workers feel specifically happy about working in the job, improving their productivity.
Also, some forms of higher wages are paid in forms that workers have to specifically allocate to tasks that employers believe will impact their productivity more. An example may be a part of wages provided in the form of compensation for various kinds of training, or subsidies to health insurance.
Increasing worker loyalty
Wages paid above the market rate help reduce churn by making other jobs seem less attractive to workers. This reduces the costs entailed in hiring and training new workers to replace workers who leave.
The increase in worker loyalty happens in two related ways:
- Workers would not voluntarily quit their jobs so readily.
- Workers would also try to avoid behavior that would have them fired, since they do not want to leave such a good job. Thus, they would be more careful to avoid shirking from work.
Avoiding adverse selection
Further information: Efficiency wage combats adverse selection in wages
A more subtle and related problem to that of turnover is that of adverse selection in wages. This is based on the idea that workers are able to estimate their individual productivity, employers find it hard to estimate the productivity of workers. Thus, if workers are paid according to the average productivity of workers, the most skilled workers may leave the job. This further pushes down average output, leading to lower average productivity, leading to lower average wages, which might push yet more workers out. This vicious cycle may continue until few good workers are left.
By providing workers with higher wages, employers can avoid problems of adverse selection and high attrition, and they can use the resources thus saved to ensure better screening processes in hiring.
Alternative explanations for apparent efficiency wage
Employers may pay workers above the market wage for a variety of reasons other than the efficiency wage.
Union power
If a large fraction of the workforce is unionized, they may be able to negotiate higher wages than the competitive wage.
Minimum wage laws or government subsidies
Minimum wage laws imposed by governments or regulatory agencies, or other government incentives that subsidize certain forms of wages and perks, may result in wages that are higher than the competitive wage. For instance, subsidies to insurance for workers, retirement saving contributions, or other perks, may result in a larger quantity of wages including perks. (The direct wages do get depressed but there is likely to be a net increase).