Efficiency-Wage Theory
The market-clearing wage is the wage at which supply equals demand; there is no excess supply of labor (unemployment) and no excess demand for labor (labor shortage). In the basic economic theory, in the long run the economy will achieve this market-clearing equilibrium and will experience the natural level of unemployment. However, firms may choose to pay wages higher than the market-clearing equilibrium in order to incentivize increased worker productivity or to reduce turnover. This is called efficiency-wage theory.
Why Pay Efficiency Wages?
There are several theories of why managers might pay efficiency wages:
- Avoiding shirking: If it is difficult to measure the quantity or quality of a worker's effort, 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 increase the cost of job loss, which gives a sting to the threat of firing. This threat can be used to prevent shirking .
- Minimizing turnover: As mentioned above, 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 when it is expensive to train replacement workers.
- 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, and this may make it profitable to offer wages that exceed the market clearing level.
Consequence of Efficiency Wage
The consequence of the efficiency wage theory is that the market for labor does may not clear and unemployment may be persistently higher than its natural rate. Instead of market forces causing the wage rate to adjust to the point at which supply equals demand, the wage rate will be higher and supply will exceed demand. This produces higher wages for those who are employed but higher levels of unemployment.