Efficiency Wage - Overview

Overview

There are several theories (or "microfoundations") of why managers pay efficiency wages (wages above the market clearing rate):

• Avoiding shirking: If it is difficult to measure the quantity or quality of a worker's effort—and systems of piece rates or commissions are impossible—there may be an incentive for him or her to "shirk" (do less work than agreed). The manager thus may pay an efficiency wage in order to create or increase the cost of job loss, which gives a sting to the threat of firing. This threat can be used to prevent shirking (or "moral hazard").

• Minimizing turnover: By paying above-market wages, the worker's motivation to leave the job and look for a job elsewhere will be reduced. This strategy makes sense because it is often expensive to train replacement workers.

• Adverse selection: If job performance depends on workers' ability and workers differ from each other in those terms, firms with higher wages will attract more able job-seekers. An efficiency wage means that the employer can pick and choose among applicants to get the best possible.

• Sociological theories: Efficiency wages may result from traditions. Akerlof's theory (in very simple terms) involves higher wages encouraging high morale, which raises productivity.

• Nutritional theories: In developing countries, efficiency wages may allow workers to eat well enough to avoid illness and to be able to work harder and even more productively.

The model of efficiency wages, largely based on shirking, developed by Carl Shapiro and Joseph E. Stiglitz has been particularly influential.