What Are Efficiency Wages?

In labor economics, efficiency wages are a level of wages paid to workers above the minimum wage to retain a skilled and efficient workforce. Efficiency wage theory posits that an employer must pay its workers high enough so that workers are incentivized to be productive and that highly skilled workers do not quit. Efficiency wages may also be paid to workers in industries that require a great deal of trust—such as those working in precious metals, jewels, or finance—to help ensure that they remain loyal.

Efficiency wage theory helps explain why firms seem to overpay for labor by arguing that these increased wages boost overall productivity and profitability for a firm over the long run.

Understanding Efficiency Wages

Efficiency wages were theorized as far back as the 18th century when classical political economist Adam Smith identified a form of wage inequality where workers in some industries are paid more than others based on the level of trustworthiness required. For instance, Smith identified that those working for goldsmiths or jewelers, while often just as skilled as those working for blacksmiths or other craftsmen, were paid relatively more per hour. Smith supposed that this must be due to the need to incentivize such workers from stealing these more valuable products.

The solution to this puzzle is that efficiency wages solve a principal-agent problem so that without such high wages, employers would be hard-pressed to keep their workers productive and loyal.

Why Pay Efficiency Wages?

Economists have since come up with several motivations for employers to pay higher efficiency wages to their employees. The most common include:

• Reduce employee turnover: Higher wages discourage workers to quit. This is especially important if hiring and training new workers is a time-consuming and costly pursuit.
• Raise morale: Similarly, an efficient wage can keep workers happier and minimize the number of disgruntled employees who can bring down morale among others and slow down production.
• Increase productivity: Higher wages lead to more productive workers who produce relatively more goods per hour and show greater effort. These wages also reduce so-called shirking (being lazy on the job) and cut down on absenteeism.
• Attract and retain skilled workers: While unskilled workers may be viewed as somewhat interchangeable from the perspective of management, highly skilled workers are often in higher demand and shorter supply.
• Trust and loyalty: Higher-paid workers tend to be more loyal to a company and are far less likely to steal or undercut the company's bottom line.

Efficiency Wage Theory

While the efficiency wage concept dates back a couple of centuries, it was only formalized by economists during the second half of the 20th century. Notable examples include Joseph Stiglitz and his work on shirking. Working with colleagues, Stiglitz proposed that, when employment is high, workers that are dismissed can easily find new employment. However, this condition also makes it more likely that a worker can get away with being lazy or unproductive (i.e., "shirk on the job"). But, since shirking reduces a firm's profitability, employers are incentivized to raise wages to counteract this and motivate their workers. Stiglitz won the Nobel prize in economics in 2001, in part for this work.

George Akerlof, another Nobel prize winner, also worked on efficiency wages by advancing the hypothesis that wages remain "sticky," even in times of economic malaise, whereby employers do not reduce the salaries of their employees. Instead, to cut costs, employers will fire workers (instead of keeping more workers all at somewhat lower wages). However, this increases the rate of involuntary unemployment. Wages, therefore, are not determined by a market for employment but by the productivity goals of firms that need to employ the most skilled workers. Akerlof, working with Janet Yellen, argued that a company can best economize on training and hiring costs by laying off some workers when the economy struggles instead of cutting wages for all of its employees across the board.

The Bottom Line

Efficiency wages are the level of wages paid to workers above the minimum wage to retain a skilled and efficient workforce. In the 18th century, Adam Smith identified a form of wage inequality where workers in some industries are paid more than others based on the level of trustworthiness required.