Paying above the market, a tested strategy

Efficiency wage theory holds that a wage above the equilibrium level can be profitable, by reducing staff turnover, attracting better candidates and raising the effort supplied.

It was formalised in the 1980s by several economists, including Carl Shapiro and Joseph Stiglitz, and it provides an explanation for why wages do not fall in periods of high unemployment. In their 1984 model, a high wage makes job loss costly and deters slackening effort.

George Akerlof proposed a different version in 1982, based on gift exchange: a wage perceived as generous calls in return for more effort than is required. The two mechanisms predict the same employer behaviour for distinct reasons.

The most cited example is Ford's decision in 1914 to raise the daily wage to five dollars, about double the previous level, in a context of extremely high staff turnover.

Historical analyses, notably those of Daniel Raff and Lawrence Summers, conclude that the measure reduced turnover and absenteeism and was probably profitable, while stressing the particular conditions of the period: new and very arduous assembly-line work, and output that was easy to measure.

Experiments raising pay unexpectedly generally find a short-lived rise in effort, which fades quickly. The one by Uri Gneezy and John List, published in 2006, observes an effect limited to the first hours of work.

Those announcing the wage before hiring find more durable effects, running mainly through candidate selection rather than increased effort by the same people. An experiment conducted in Mexico by Ernesto Dal Bó, Frederico Finan and Martín Rossi, published in 2013, shows that a higher offer attracts more qualified candidates without lowering their reported motivation.

The same work finds a marked asymmetry: a wage cut produces a negative effect on effort far stronger than the positive effect of an equivalent rise.

That asymmetry is one of the arguments advanced to explain downward nominal wage rigidity, a phenomenon observed in payroll data in many countries. The interviews Truman Bewley conducted with managers, published in 1999, find the same justification: the fear of lastingly damaging team morale.

The profitability of a high wage depends on the sector, on the cost of turnover and on how easily individual output can be measured. No general conclusion transfers from one context to another.

Work on minimum wage increases poses a neighbouring but distinct question, that of employment effects, and its results do not follow from this literature. The minimum wage is imposed on all firms, whereas the efficiency wage presupposes a voluntary gap with competitors.