Efficiency Wage - Empirical Literature

Empirical Literature

Raff and Summers (1987) conduct a case study on Henry Ford’s introduction of the five dollar day in 1914. Their conclusion is that the Ford experience supports efficiency wage interpretations. Ford’s decision to increase wages so dramatically (doubling for most workers) is most plausibly portrayed as the consequence of efficiency wage considerations, with the structure being consistent, evidence of substantial queues for Ford jobs, and significant increases in productivity and profits at Ford. Concerns such as high turnover and poor worker morale appear to have played a significant role in the five-dollar decision. Ford’s new wage put him in the position of rationing jobs, and increased wages did yield substantial productivity benefits and profits. There is also evidence that other firms emulated Ford’s policy to some extent, with wages in the automobile industry 40% higher than in the rest of manufacturing (Rae 1965, quoted in Raff and Summers). Given low monitoring costs and skill levels on the Ford production line, such benefits (and the decision itself) appear particularly significant.

Fehr, Kirchler, Weichbold and Gächter (1998) conduct labour market experiments to separate the effects of competition and social norms/customs/standards of fairness. They find that in complete contract markets, firms persistently try to enforce lower wages. By contrast, in gift exchange markets and bilateral gift exchanges, wages are higher and more stable. It appears that in complete contract situations, competitive equilibrium exerts a considerable drawing power, whilst in the gift exchange market it does not.

Fehr et al. stress that reciprocal effort choices are truly a one-shot phenomenon, without reputation or other repeated-game effects. “It is, therefore, tempting to interpret reciprocal effort behavior as a preference phenomenon.”(p344). Two types of preferences can account for this behaviour: a) workers may feel an obligation to share the additional income from higher wages at least partly with firms; b) workers may have reciprocal motives (reward good behaviour, punish bad). “In the context of this interpretation, wage setting is inherently associated with the signalling of intentions, and workers condition their effort responses on the inferred intentions.” (p344). Charness (1996), quoted in Fehr et al., finds that when signalling is removed (wages are set randomly or by the experimenter), workers exhibit a lower, but still positive, wage-effort relation, suggesting some gain-sharing motive and some reciprocity (where intentions can be signalled).

Fehr et al. state that “Our preferred interpretation of firms’ wage-setting behavior is that firms voluntarily paid job rents to elicit non-minimum effort levels.” Although excess supply of labour created enormous competition among workers, firms did not take advantage. In the long run, instead of being governed by competitive forces, firms’ wage offers were solely governed by reciprocity considerations because the payment of non-competitive wages generated higher profits. Thus, both firms and workers can be better off when they rely on stable reciprocal interactions.

That reciprocal behavior generates efficiency gains has been confirmed by several other papers e.g. Berg, Dickhaut and McCabe (1995) - even under conditions of double anonymity and where actors know even the experimenter cannot observe individual behaviour, reciprocal interactions and efficiency gains are frequent. Fehr, Gächter and Kirchsteiger (1996, 1997) show that reciprocal interactions generate substantial efficiency gains. However the efficiency-enhancing role of reciprocity is, in general, associated with serious behavioural deviations from competitive equilibrium predictions. To counter a possible criticism of such theories, Fehr and Tougareva (1995) showed these reciprocal exchanges (efficiency-enhancing) are independent of the stakes involved (they compared outcomes with stakes worth a week’s income with stakes worth 3 months’ income, and found no difference).

As one counter to over-enthusiasm for efficiency wage models, Leonard (1987) finds little support for either shirking or turnover efficiency wage models, by testing their predictions for large and persistent wage differentials. The shirking version assumes a trade-off between self-supervision and external supervision, while the turnover version assumes turnover is costly to the firm. Variation across firms in the cost of monitoring/shirking or turnover then is hypothesized to account for wage variations across firms for homogeneous workers. But Leonard finds that wages for narrowly defined occupations within one sector of one state are widely dispersed, suggesting other factors may be at work.