The Efficiency Wage Theory

Updated Jan 20, 2023

According to the Efficiency Wage Theory, firms can operate more efficiently and become more productive if they pay wages above the equilibrium level. There are four different theories, according to which firms can benefit in four different ways from paying efficiency wages: higher employee effort, lower employee turnover, attracting higher quality employees, and more healthy employees. The reasoning behind all four approaches is simple, as long as the benefits outweigh the additional costs, companies profit from paying higher wages. Let’s look at the four theories in more detail below.

Increase in Employee Effort

The first theory suggests that workers who are paid above the equilibrium level will put in more effort than workers who are paid the equilibrium wage (or less). It is virtually impossible for firms to monitor all employees and prevent shirking completely. Some employees will always take advantage of this and slack off, even though they risk losing their job if they get caught. However, if they are paid efficiency wages, they have less incentive to shirk because their job becomes more attractive. In other words, employees are less likely to slack off because, with higher wages, the opportunity cost of losing their job increases.

If firms pay wages above the equilibrium level, it becomes more difficult for employees to find other jobs that pay equally well. As a consequence, they have an incentive to put in more effort to maintain their current job. This concept is somewhat similar to Marx’s idea of the “reserve army of labor”, which essentially states that employees are more motivated to work hard if they live in constant fear of being replaced.

Decrease in Employee Turnover

The second theory suggests that a wage above the equilibrium level reduces costly employee turnover. There are many incentives at play when employees think about quitting their job: the availability of other jobs, fringe benefits, money, and so on. As in any other economic decision-making process, the benefits are weighed against the costs. If the benefits of staying outweigh the costs, the employee will stay. Analogously, if the costs outweigh the benefits, they will quit.

From the firm’s perspective, the benefits of staying (i.e., the costs of leaving) can be increased by paying a higher wage. Even though this may not convince all employees to stay, it will certainly decrease the number of employees who want to leave the firm. This benefits the company because employee turnovers are costly. The process of hiring and training new employees takes up valuable time and resources and thus increases production costs. If employee turnover decreases, some of those resources are freed up and can be used in more efficient and lucrative processes.

Increase in Employee Quality

The third theory suggests that efficiency wages attract more skilled and higher-quality employees than equilibrium wages. Employees who are productive and highly skilled are valuable to any firm, and they know that. Thus they will demand a higher wage than lower-quality workers. They are said to have a higher reservation wage, i.e., the lowest wage at which they are willing to accept a particular job is higher than lower quality employees.

This results in a self-selection process if we assume that higher-quality workers only apply to jobs that pay above the equilibrium level. In contrast, low-quality workers will gladly work for equilibrium wages. Thus, to attract high-quality employees, firms have to offer efficiency wages. Of course, this may result in some low-quality employees being paid more than they are worth. But on average, companies who pay efficiency wages will still end up with higher quality employees than comparable firms that pay lower wages.

Increase in Employee Health

The last theory suggests that wages above the equilibrium level increase employee health and, thereby, their productivity. The reasoning behind this is that a higher salary allows employees to take better care of themselves in terms of nutrition, sleep, stress levels, etc. This increases their quality of life and results in better overall health.

Employers benefit from an increase in employee health because healthy employees are more productive than workers who are frail in health. Also, they are less on sick leave, and their healthcare costs are lower. Fortunately, in developed countries, this theory is becoming less relevant because most jobs pay enough to support a healthy lifestyle, even on the equilibrium level. However, in developing countries, many people still struggle to make a healthy living even though they are working full-time.

Summary

According to the Efficiency Wage Theory, firms can operate more efficiently and become more productive if they pay wages above the equilibrium level. Four different theories describe how firms can benefit from paying efficiency wages: higher employee effort, lower employee turnover, attracting higher quality employees, and more healthy employees. The first theory suggests that workers who are paid above the equilibrium level will put in more effort than workers who are paid the equilibrium wage or below. The second theory states that a wage above the equilibrium level reduces costly employee turnover. The third theory suggests that higher wages attract more skilled and higher-quality employees. And last but not least, the final theory suggests that wages above the equilibrium level increase employee health and, thereby, their productivity.