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.