What Are Efficiency Wages?

Efficiency wages refer to paying employees at rates above the minimum wage or market standard to boost output, profit and overall efficiency while retaining skilled workers. In theory, efficiency wages pay for themselves in the resulting productivity benefits to a company. However, there are also a few limitations to efficiency wages to consider.

Efficiency wages are, in theory, wage increases that pay for themselves due to the resulting rise in labor productivity, employee efficiency and skilled job candidates.?

While this term isn't used in everyday situations, it is still as relevant today as it was in economist Adam Smith ’s days in the 18th century. He first introduced the efficiency wage theory to help offset wage inequality among industries. At this point in history, workers in some professions made significantly more than others in roles that required a lower level of trust but a comparable level of skill or output.

By this definition, companies pay employees based on how efficient, productive and ultimately beneficial they are for business.?

Efficiency Wages Definition

In today’s economy, we see efficiency wages play out a little differently. Rather than paying employees in direct proportion to their efficiency and quantitative output, the modern model almost reverses the order of the cause-and-effect scenario: offering higher wages up front to boost efficiency as a result.?

This more modern definition of efficiency wages asserts that keeping pay well above minimum wage or market wages helps attract and retain a skilled, productive workforce even amid increased competition or economic hardship. These pay rates may also be set for industries with high stakes and trust, such as jobs dealing with finance or scarce resources.?

What Is Efficiency Wage Theory?

Formalized during the latter half of the 20th century, efficiency wage theory is economists’ philosophy that employers must pay employees high enough to incentivize productivity while retaining highly skilled workers. Of course, for a business, a boost in efficiency and output means more long-term profitability. Efficiency wage theory, then, suggests various benefits to efficiency wages.

Efficiency Wage Advantages?

Limits Shirking and Increases Productivity?

Efficiency wage theory claims that paying higher wages means less shirking , or slacking off, from workers. Instead, the workplace will be more efficient with the increased effort from motivated employees plus the greater output of goods produced per hour.

Reduces Employee Turnover Rate?

Simply put, better wages encourage workers to stay with a company and not quit for a higher-paying opportunity. Particularly if an organization’s hiring and training process require a lot of effort and resources, reducing turnover rates is important.?

Attracts Higher-Quality Candidates

Recruiting highly skilled candidates is often challenging because they are in shorter supply yet greater demand in the job market. One guaranteed way to attract higher-quality applicants for the long term is to raise wages above the standard market level.?

Instills Loyalty and Trust

Efficiency wages may also build and solidify trust among employees. Generally, workers who are paid higher are more likely to remain loyal and less likely to hurt a company’s bottom line.

Increases Employee Morale

According to efficiency wage theory, higher pay equals higher workplace morale. With happier employees comes higher-quality work and fewer snags in production.

Example of Efficiency Wage Theory in Practice?

The most well-known instance of efficiency wage theory in action today is Amazon. In 2022, The corporate giant executed a global wage increase for its lowest-paid staff. Aside from a more positive public perception a move like this would garner, the company also sought improvement in efficiency, productivity and profitability by incentivizing workers with higher pay.?

Another example from the past is Henry Ford, who saw great success in paying employees wages above market level. In 1914, Ford increased the minimum wage to $5 for an 8-hour workday, nearly double the previous pay rate.

Efficiency Wage Theory Limitations?

Wages Only One Part of Morale

Although wages can directly influence morale, other foundational factors contribute to how employees feel about a workplace, too. Management, peer dynamics, work conditions and growth opportunities are key to ensuring job satisfaction.?

Competing Businesses?

When industry competitors follow the efficiency wage model, a business may not be able to attract better candidates than the competition.?

Monopsony Makes Increasing Wages Ineffective?

In a monopsony , a single firm holds market power over factors of production, such as labor. Thus, workers in that specific industry have fewer alternative options if they were to lose or leave their jobs. A company with monopsony power has less incentive to increase wages because there is less of a payoff in productivity and profits.?

Final Thoughts: Are Efficiency Wages Right for Your Organization?

Depending on your combination of business needs, efficiency wages can certainly offer a range of business benefits. Understanding the economic theory and your company’s place in the market is crucial to executing the most effective strategy.?

Higher pay drives employees to perform their best. However, efficiency wages aren’t sustainable for every organization. It is important to decide what the extra effort from employees and added productivity is truly worth to your business in the long run.

Top Takeaways

What are efficiency wages?

• Efficiency wages refer employers offering pay rates above the minimum wage or market standard to retain skilled workers and reap production benefits.
• Efficiency wage theory explains the advantages of higher pay and why most companies will not cut wages even amid competition or economic hardship.
• Higher wages can help reduce employee turnover while increasing productivity, loyalty and morale.?
• Limitations of efficiency wages often involve business competition or, on the other hand, a lack thereof — rendering wage increases unnecessary.

(Reporting by NPD)