Five Reasons Wages and Productivity Have a Positive Relation

Andrea Wieland 4/10/03 Efficiency Wages

The theory of efficiency wages says that it is logical for some firms to pay wages that are above the market wage. The reasoning behind this theory states that productivity can be related to wages. In other words, in some cases the mere fact that workers are paid more can make them more productive. This means that the total productivity curve at some points can be upward sloping.

Of course after some point the curve will flatten out. By drawing a line from the origin you can find the elasticity of a specific point. This makes it easier to be determined what point will be most efficient.

The most efficient elasticity equals one. Point x that is the point tangent to the origin and closest to the output axis has the elasticity of one. Looking at the total product curve you see that the wage increase from point y to x is very small compared to the increase in output. It is also easy to notice that if you make the large wage increase from point x to z the output increase is very small in comparison. Therefore the most efficient point is point x regardless if the supply and demand equilibrium point is below x. Of course if the supply and demand equilibrium is above point x then the efficiency wage doesn’t matter, because you will have to pay above the efficiency wage in order to attract workers. There are examples of possible efficiency wages in practice and there are also critics to the approach. Now we will look at why wages would increase workers productivity. Andrea Wieland 4/10/03 There are five good reasons why efficiency wages would increase productivity.

Five reasons wages and productivity have a positive relation

1. It makes nutrition more affordable. 2. Some workers will be afraid to loose such high wages if their performance doesn’t meet expectations. 3. The employer gets a choice of the cream of the crop. 4. Saves the employer the cost of high turnover rates. 5. Sociology of the work place

First studies have shown that workers who are undernourished are less productive than workers that have adequate nutrition. It only makes sense that a more healthy person will perform better and call off less. The economist John Strauss did research in an African country Sierra Leone. A ten percent increase in caloric intake among farm workers in

Sierra Leone increases productivity by about 3.4 percentage points.1

Second efficiency wages can be used to lower the monitoring cost. Economist recognize this possibility as an example of moral hazard—the tendency of people to behave inappropriately when their behavior is imperfectly monitored.2 In the fast food business it has been proven that worker who work for the corporation get paid more than workers who work for local franchise stores. This could imply that a local franchise has lower monitoring cost and therefore doesn’t need to pay higher wages. Whereas a corporation restaurant has more cost in supervising a store that is farther away and therefore find that it’s cheaper to pay the workers more instead of paying the monitoring cost. Other businesses have high monitoring cost and find it easier to just hirer workers at a higher wage and let employees know that poor workers will be fired.

1 John Strauss, “Does Better Nutrition Raise Farm Productivity?” Journal of Political Economy 94 (April 1986): 297-320 2 Gregory N. Mankiw Macroeconomics Worth Publisher New York 2003 Andrea Wieland 4/10/03 Sometimes hiring people at a higher wage will attract workers who are more productive who have a higher reservation wage. Some people might feel that the job is less strenuous than another job paying the same wage. Therefore what worker wouldn’t want to switch jobs? As the employee gets a more productive worker the worker gets to work at a job where they can be less productive. If a firm reduces its wage, the best employees may take jobs elsewhere, leaving the firm with inferior employees who have fewer alternative opportunities. Economist recognize this unfavorable sorting as an example of adverse selection—the tendency of people with more information (in this case, the workers, who know their own outside opportunities) to self-select in a way that disadvantages people with less information (the firm).3 Efficiency wages allow employers to pick the cream of the crop from surplus of workers.

Turn over cost can be very high for employers. Employers have to pay the cost of loss of productivity while searching for a new employee, plus the cost of finding a new employee and training the new employee. Why would any employee leave a company when they knew that they wouldn’t get paid as much anywhere else?

The Sociology of the work force deals mostly with a social issue and not an economic issue. It states that people will have good feelings about their work and employer and therefore work harder. It seems unlikely that an entire firm would work more productively.

Some workers will just feel good about the high wages and work the same.All of these things can be demonstrated in the first use of efficiency wages. Henry Ford revolutionized the car industry with the use of the first continuous assembly line.

Workers specialized to the point that it took 5 minutes to learn the task required of them.

3 Gregory N. Mankiw Macroeconomics Worth Publisher New York 2003 Andrea Wieland 4/10/03 This led to a boring work place that almost encouraged worker to call off and quit.

Annual turnover at the ford plant was nearly 370 percent in 1913. In addition, the absenteeism rate was nearly 10 percent daily. In 1914 the Ford Motor Company decided to disregard the wage and employment conditions that had been presumably set in the competitive labor market and unilaterally reduced the length of the workday from 9 to 8 hours and more than doubled the wage from $2.34 to $5.00 per day. By 1915 the turnover rate had dropped to 16%, the absenteeism rate had dropped to 2.5 percent, productivity per worker had increased between 40 and 70 percent, and profits had increased by about 20 percent.4 The argument could be made that the workers were getting underpaid according to sufficiency wages because of the disadvantage of the tediousness of the job. This would lead you to believe that once the wage was raised it actually reached equilibrium. Maybe people were just beginning to understand that boredom has a cost just like risk must be paid more than a safe job. There is some evidence that Inter-Industry wage differentials can be interpreted in different ways.

Some suggest that since most people who leave a job and transfer to another company usually get paid more this means that the new job pays efficiency wages. Sumner

Slichter (1950) was among the first economist to study the industry wage structure.

Sumner was struck by the magnitude of industry wage differences for comparable workers.5 Others argue that the pay difference is due to sticky wages. The evidence for efficiency wages does say that the wage difference is not due to socioeconomic background, differences in jobs, or worker characteristics.

4 Daniel M.G. Raff and Lawrence H Summers, “Did Henry Ford pay Efficiency Wages?” Journal of Labor Economics 5 (October 1987, Part 2): S57-S86 5 Alan B.Krueger and Lawrence H Summers, “Efficiency Wages and the Inter-Industry Wage Structure” Econometrica, Wol.56, No. 2. (Mar., 1988) : 259-293 Andrea Wieland 4/10/03 Critics would argue the sticky wage theory. Arguing that some employers are in a time period when they can’t change wages to a hirer place therefore what may appear to be the labor market equilibrium really isn’t. Other employers are able to move to the higher place and therefore make higher profits. Another theory is known as the bonding theory. If one place were hiring a limited number of workers at a higher price workers would want to buy that job. Something like indentured servitude, or in modern times possible delayed wages. As we discussed earlier when a job pays for workers education the worker is the one that pays in the form of lower pay. When the education is increased the pay is increased. This would suggest at the present time all wages are equal. The bonding critique, therefore, suggests that efficiency wages models would self-destruct in the long run.6 Unfortunately the evidence to support the bonding critique or efficiency wages is not conclusive.

Others critics argue that efficiency wages causes more unemployment, because of the high wage. The result of this higher- than-equilibrium wage is a lower rate of job finding and greater unemployment.7

As you can see from the supply and demand diagram the efficiency wage causes a surplus of workers. Some of the people who will get the jobs are people with higher reservation wages and not the people who would otherwise

6 George J Borjas Labor Economics Irwin McGraw-Hill Boston 2000 7 Gregory N. Mankiw Macroeconomics Worth Publisher New York 2003 Andrea Wieland 4/10/03 get the job. As we mentioned before the there is still a debate about weather inter- industry efficiency wages exist. Krueger believes the stability of the industry wage structure casts doubt on explanations of wage differentials based on the short run immobility of labor or transitory labor demand shocks. It is unlikely that labor is sufficiently immobile over several decades or even one decade to allow such large differentials to persist.8

All in all for whatever reason sometimes raising the wage even if all the other companies are staying the same can make sense. The logic is there even if the sources of the logic, the economist continue to argue about.

8 Alan B.Krueger and Lawrence H Summers, “Efficiency Wages and the Inter-Industry Wage Structure” Econometrica, Wol.56, No. 2. (Mar., 1988) : 259-293