Efficiency wage hypothesis Guide, Meaning , Facts, Information and Description

In labor economics, the efficiency wage hypothesis argues that wages are determined by more than simply supply and demand. Specifically, it points to the incentive for managers to pay their employees more than the market-clearing wage in order to increase their productivity, i.e., their "efficiency." (Thus, the name of the hypothesis.) This increased labor productivity pays for the relatively high wages.

In their book, Efficiency Wage Models of the Labor Market (ISBN 0 521 31284 1), George A. Akerlof and Janet Yellen point to several theories (or "microfoundations") of why managers pay efficiency wages:

• 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." The manager thus may pay an above-market-clearing (AMC) wage in order to create or increase the "cost of job loss," which gives a sting to the threat of the "sack." This threat can be used to prevent shirking.

• Minimizing Turnover: By paying AMC wages, the employees' incentive to quit and seek jobs elsewhere is minimized. 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 AMC wage means that the employer can pick and choose among applicants to get the best possible.

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

• Nutritional Theories: In a theory relevant to poorer countries, AMC wages allow workers to eat well enough to avoid illness and to be able to work harder and more productively.

Though there are criticisms of these theories (which Akerlof and Yellen summarize), even if only partially true, the implications of the efficiency wage hypothesis can undermine the conclusions of neoclassical economics. In most of these the above, wages are determined by the inner workings of the operations of the firm, implying that wages are limited by supply and demand rather than being determined by those forces. Further, the market clearing presumed by most economists may not occur.

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