6 Efficiency wages
In a basic model of labour market equilibrium, the wage adjusts so that there is neither excess demand nor supply. This is the “market clearing” level.
The idea behind efficiency wages is that firms might pay wages above the market clearing level to increase employee productivity. Two of the traditional economic explanations are as follows:
- Reducing shirking: Where it is not possible to perfectly observe worker effort or output, paying an efficiency wage will increase the cost of job loss, meaning threats to fire in case of poor performance have teeth.
- Reducing turnover: Hiring and training replacement workers is costly. An efficiency wage might reduce worker motivation to leave the job.
If all firms in a market pay efficiency wages, there may be involuntary unemployment at equilibrium. Unemployed workers cannot credibly signal that they will work for lower wages as they may then shirk.
6.1 A case study: Ford
By 1913, Ford Motor Company faced critical workforce issues with annual turnover reaching 370% (Raff and Summers, 1987). Over 50,000 workers were required to be hired annually to maintain a workforce of around 13,500. Daily absenteeism was 10%.
Ford’s production had evolved from skilled craftsmanship to assembly line work with highly routinised tasks requiring minimal skill. This technological shift created harsher working conditions and increased pressure on workers, driving the high turnover and absenteeism.
6.1.1 The Solution
Ford addressed these problems by doubling the minimum daily wage from $2.34 to $5 while reducing the workday from 9 to 8 hours. Ford stated the wage increase was “one of the finest cost cutting moves we ever made,” suggesting productivity considerations rather than philanthropy drove the decision.
6.1.2 The Results
Turnover plummeted from 370% in 1913 to 54% in 1914 and further to 16% in 1915. Absenteeism fell from 10% to 2.5%, while annual discharges decreased by 90%. Most importantly, productivity increased by 40-70%. Despite doubling wages, the cost of making a Model T chassis decreased.
6.1.3 Mechanisms
The Ford case demonstrates several efficiency wage mechanisms working together. Reduced turnover generated savings, though calculations suggest this alone offset only 6 to 19% of the wage increase cost, indicating other factors were involved. Workers also increased their effort, shown by sharp drops in absenteeism and discipline problems.
By increasing wages above market rates, Ford reduced costly turnover, increased worker effort, and ultimately enhanced productivity and profits, in line with efficiency wage predictions.