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Birks – Efficiency wage

A commentary on Supply and demand

By Stuart Birks

One example of a market where a price above the equilibrium is described as being justified is that of an “efficiency wage”. It is argued that employers are prepared to pay above the market clearing wage because it gives them greater employee loyalty and more choice over potential new employees. It is interesting because it demonstrates the existence of important criteria that are not covered (i.e. are assumed away) in the standard model. In particular, there may be costs associated with labour turnover. These could include hiring costs, layoff costs, firm-specific training for new employees and disruption to production with changes in staff. Consequently employers may wish to retain existing workers. A more loyal workforce may also be more motivated and hence more productive. This latter point suggests that there is not a fixed relationship between inputs and outputs as assumed in the standard production function where output is a function of quantities of capital and labour inputs. The suggestion that choice of employees might be important reflects the heterogeneity of labour, contravening the basic homogeneity assumption in a supply and demand model.

Given that there are several additional dimensions besides a price signal that could be considered, it is surprising that textbooks have focused only on the idea of an efficiency wage. It may be that the market model, with its emphasis on price and the price mechanism, leads us down this path. However, we could consider a much broader picture.

Consider an employer with objectives of staff retention and employee motivation, commitment and productivity. There are many ways in which this could be achieved, especially if we also consider ways that an employer can attempt to meet employees’ objectives. Just as an initial list, we could think of: job security; promotion prospects; training opportunities; flexible hours; child care facilities; pension schemes; health insurance cover; pleasant, safe, healthy work environment; company car; staff cafeteria; longer holidays; shorter hours; company social functions; good company public profile/reputation; share options; travel and/or relocation possibilities.

No doubt you could add to this list. It suggests that simplified textbook models may give plausible explanations of and provide some insights into some real world phenomena, but the framing of the issues may also blinker us and limit the possibilities that we might consider.

[This is Pointer No.33 in Birks S (2015) 40 Critical Pointers for Students of Economics, Bristol: World Economics Association Press]

Commentary added 24th October 2015

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