Efficiency Wage
What is Efficiency Wage?
An efficiency wage is a wage set above the market level to boost worker productivity, loyalty, and retention.
Paying more can reduce turnover, attract better workers, and motivate effort because losing the job is costlier. It is one explanation for why wages can stay above market-clearing levels, contributing to unemployment.
Efficiency Wage: a worked example
A warehouse pays the going wage of $20 an hour and each worker sorts 30 packages an hour, so unit labor cost is $20 / 30 = $0.667 per package. Management raises pay to $25, well above the market. Stronger applicants apply, effort rises because the job is now worth keeping, and output climbs to 40 packages an hour. Unit labor cost falls to $25 / 40 = $0.625 per package. Across 6,000,000 packages a year, total labor cost drops from 6,000,000 x $20 / 30 = $4,000,000 to 6,000,000 x $25 / 40 = $3,750,000, a saving of $250,000. Turnover savings stack on top: if replacing a worker costs $3,000 and quits fall from 40 a year to 15, the firm saves 25 x $3,000 = $75,000. The hourly wage went up 25% while the cost of actually getting the work done went down.
The mistake students make with efficiency wage
Students argue that a wage above the market must raise costs, so no profit-maximizing firm would ever pay one. That confuses the wage rate with cost per unit of output: when output per worker rises faster than pay, the wage bill per package sorted falls and profit rises. The opposite error treats the productivity gain as automatic and unlimited. Screening, effort, and retention effects run out, so a firm that keeps pushing pay eventually adds 10% to the wage and 2% to output, and unit labor cost climbs 7.8%. The efficiency wage is the level where that trade stops paying.
Efficiency Wage questions
Why would a firm pay workers more than it has to?
Firms pay above market when the higher wage lowers cost per unit of output. Four channels do the work: better applicants select into the job, current workers shirk less because dismissal now costs them a premium, quits and the training bills that follow drop, and morale improves. Monitoring effort worker by worker is expensive, so paying a premium that makes the job worth protecting can be the cheaper way to buy effort.
How do efficiency wages explain unemployment?
Efficiency wages hold pay above the market-clearing level, so more workers want these jobs than firms will hire, and the surplus shows up as unemployment. The wage does not fall to clear the market because cutting it would destroy the productivity gain the firm is paying for. Unemployed workers cannot undercut insiders either, since a firm that hired them cheaply would lose the effort and retention effects it wanted in the first place.
How is an efficiency wage different from a minimum wage?
An efficiency wage is one firm's voluntary choice to pay above the market because the higher pay lowers its own cost per unit of output. A minimum wage is a legal floor set by government that binds every covered employer whether or not the higher pay earns its keep. Both can hold pay above the point where labor supply meets labor demand, but only the minimum wage is imposed from outside, and a firm drops an efficiency wage as soon as the productivity gain stops covering it.
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