Question

Briefly explain the four rationales for efficiency wages.

Answer 1

There are four different theories, according to which firms can benefit in four different ways from paying efficiency wages: higher employee effort, lower employee turnover, attracting higher quality employees, and more healthy employees.

Increase in Employee Effort- The first theory suggests that workers who are paid above the level of equilibrium will put in more effort than (or less) workers who are paid the balance wage. Companies are practically unable to track all the workers and absolutely stop shirking. Some employees will always take advantage of this and slack it off, even though if they get caught they risk losing their job. If they get paid productivity salaries, however, they have less reason to shirk, as their work becomes more desirable. In other words, employees are less likely to slack out because the opportunity cost of losing their job increases with higher wages.

Decrease in Employee Turnover- The second theory suggests a wage above the level of equilibrium would reduce the costly turnover of employees. When employees think about quitting their job, there are many incentives at play: the availability of other jobs, fringe benefits, money and so on. As in every other method of economic decision taking, the benefits are balanced against the costs. If the benefits of staying outweigh the costs, then remain with the employee. Analogously they will leave if the costs outweigh the benefits.

Increase in Employee Quality- The third principle indicates that more professional and higher performing workers receive productivity salaries than equilibrium salaries. Employees that are successful and highly qualified are, and know that, important for any company. Thus they will demand a higher wage than lower-quality workers. They are said to have a higher reservation pay, i.e. higher than lower-quality workers is the lowest salary they are able to take on a specific job.

Increase in Employee Health- The last theory suggests that wages above the level of equilibrium increase the health of employees and thus their productivity. The reasoning behind this is that a higher salary enables employees to take better care of themselves in terms of nutrition, sleep, levels of stress etc. This will enhance their quality of life and lead to better overall health. Employers benefit from an improvement in the health of staff, as healthy employees are more successful than poor health workers. There are also fewer on maternity leave, so they have lower healthcare expenses.